Asset allocation has largely replaced old-fashioned stock picking in the advisory world.
Central to an allocation strategy is the assignment of weightings within a portfolio. As a simplistic illustration, a client’s plan may determine an ideal allocation of 60% stocks and 40% bonds. In 2020, that portfolio’s stock weighting may have drifted to something more than 60% as equities raced higher.
When that happens, a financial advisor will rebalance the portfolio by selling stocks and putting the proceeds into bonds, getting the portfolio back to the original 60-40 allocation.
In practice, it’s more complex than that. Portfolios are generally constructed using more than two funds, and asset classes are broken down to a more granular level.
Advisors rarely rebalance the day a portfolio becomes misaligned with its original allocation. Some use tolerance bands or corridors, meaning they will rebalance when a portfolio drifts a certain percentage. Others use a calendar system, reviewing portfolio weightings once or more per year.
All these ways can be effective, says Philipp Meyer-Brauns, vice president and senior researcher at Dimensional Fund Advisors in Austin, Texas.
Dimensional’s research found that investors can keep their portfolios on track through rebalancing.
“It’s not a tool to increase your returns, although there are some papers out on that topic, saying that you can reliably get higher returns. We don’t find that in our research,” Meyer-Brauns says.
“The most important thing is that you have a plan and stick to it,” he adds. “Rebalancing is an investor tool to keep your portfolio on track and aligned with who you are as an investor: your risk tolerance, preferences, return needs and expectations.”
As the market and economic conditions change, advisors often rethink their approach to rebalancing.
“My concern is that old rules don’t apply right now,” says Lee Baker, owner and president at Apex Financial Services in Atlanta. “The liquidity that has been injected into the financial system, while necessary, makes me wonder about what it means on the back end.”
Automated or Semicustom Approach
Baker cites the example of fixed income. Many bond yields have been near record lows, with analysts expecting this situation to continue into the foreseeable future. If that forecast pans out, it could affect retirement income for many Americans.
“What we have typically expected to get out of bonds is unlikely to be available in the near term,” Baker adds. “So the question becomes: How do we get the return and income for our clients without creating too much downside risk?”
Baker uses model portfolios in client accounts and manually rebalances each quarter, “unless extreme movements, like this spring, require attention,” he says.
“I prefer a more hand-tailored approach or perhaps a semicustom,” he says. “I like to think of it as buying a nice suit off the rack and then getting it altered so it gives you the best fit.”
Josh Womack, investment manager at Womack Financial in Dallas, turns to a more automated approach.
“Rebalancing appropriately keeps portfolios in line with expectations and is paramount to keeping the risk-reward dynamic in check,” he says. “As our practice grows, having an account slip through the cracks, without routine rebalancing, is a real concern. Leveraging technology not only reduced the time required to rebalance portfolios, but it helped reduce the risk that any account is left out of the rebalancing process.”
To address that concern, Womack uses Autopilot, a rebalancing tool from Riskalyze, a fintech company that helps advisors identify risk levels in portfolios and constructs new portfolios better aligned with investors’ goals.
Customization is Required
Aaron Klein, CEO and co-founder of Riskalyze, says his firm set out to address specific processes when it rolled out Autopilot. Rebalancing products from other fintech providers already existed, but Klein saw room to improve upon their limitations.
“The biggest challenge with legacy rebalancers is their rigid, inflexible models-based approach to solving the problem of scale and automation for an advisor’s client accounts. It just doesn’t fit the real world of how advisors actually work,” he says, explaining that’s why Riskalyze allows advisors to use various iterations of model portfolios.
Customization is essential. Even for advisors who use model portfolios, there are cases where wholesale rebalancing is not possible or desirable. For example, a client may own a security that he or she simply doesn’t want to sell, for a variety of reasons.
Klein says his company set out to change the paradigm.
“Instead of a spreadsheet of trades, it’s more of an intelligent inbox, where advisors can pop in and make quick decisions to keep client accounts on track,” he says. “We also bet early on that taxes would always be complicated, and an opportunity for advisors to deliver value, so we’ve been laying the groundwork from the beginning to build tax intelligence into the product.”
Klein is referring to the dilemma advisors face when rebalancing taxable accounts. For example, in the past several years, with the U.S. stock market rallying to new highs, investors who sold shares often found themselves owing a hefty amount in capital gains tax.
Use the Tools Properly
Womack appreciates how fintech has made the process more efficient.
“The tools available to advisors continue to grow, which is an amazing thing for both advisors and our clients,” he says. “Finding the right tools is key, but using any tool properly is more important than always finding the best, newest, shiniest tool.”
Regardless of the timetable for rebalancing and which tools are used, staying the course is the best way to keep a portfolio on track for the desired return and risk levels, says Meyer-Brauns.
“Let’s say you have a certain plan for rebalancing, depending on how far your portfolio is off target, but now March 2020 comes around, and stocks are down 30% or 35%. The plan says to buy stocks, but if we put ourselves in the shoes we were in, in early March, that is not always easy,” he says regarding the mid-March sell-off that occurred at the beginning of the pandemic.
“It’s also not something that may immediately pay off,” he adds. “Obviously this year, in hindsight, the market rallied, so it would have worked well, but that’s not always guaranteed.”
Meyer-Brauns says it’s not necessarily easy to maintain the discipline of adhering to an investment philosophy and a rebalancing plan.
“Have a plan and stick to it as much as you can, even if going gets rough,” he says, citing this year as an example. “It sounds simple to set this up, but it’s not always easy when you have that feeling in the pit of your stomach like we had in March. But science ad historical data tell us the best thing you can do is not try to predict where things are going, but have one investment philosophy you can stick with.”
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